Looking Beyond the Yield Curve - Articles & Commentaries

ADDED:

23 July 2019

PREPARED BY:

If you’re a keen market observer, you would have read about the yield curve inverting which sent chills down the spine of investors globally. Financial and business news outlets were in a frenzy to point out that a key financial indicator was flashing warning signals that a recession is looming ahead.

Benchmark gauges surrendered gains back in March due to recessionary fears when the spread between the 3-month and 10-year Treasury note went negative for the first time this year since a decade ago. A pallid economic picture painted by the US Federal Reserve which downgraded its economic outlook and tilted its policy stance towards a more dovish approach also added to concerns.

But how accurate is the yield curve as a dark omen for markets that an imminent economic slump is coming for us all? Here is what you need to know about the yield curve and what bond markets are trying to tell investors.

Yield Curve Inversion, Explained…
Logically, people would demand higher interest rates for longer-term loans because the risk is higher over longer time horizons. Think about your fixed deposits (FD), where the longer your FD placement is with a bank, the higher your rate of return. So, a normal yield curve would have an upward slope indicating higher yields for longer-dated maturities.

A yield curve inverts when yields for longer-dated maturities fall below shorter-dated maturities. As mentioned earlier, the yield for the 10-year Treasury note dipped below the 3-month yield back in March’19 which is a rare occurrence in markets. This means that an investor is now getting paid more to hold shorter-dated maturities.

Source: Bloomberg, as at 29 Jun 2019

For the yield curve to invert implies that bond markets are pricing-in lower expectations about future growth and that inflation is going to stay low. Technically, it also signals expectations of lower interest rates and that central banks would stay dovish to help spur economic activity.

Bond markets are trying to surmise why interest rates need to come down (for whatever reason) to justify long-term yields being low, in spite of the risk that comes with a longer-dated bond. Essentially, this means that the long-term picture is unclear and it’s unlikely to be calm waters. Most investors read this as a sign of a recession.

Time to Panic and Sell?
Whilst any predictions of when a recession would hit is typically a fool’s errand, the 3-month/ 10-year yield curve has been historically accurate in predicting a US recession. Indeed, a yield curve inversion has preceded each of the last 7 recessions over the years. Thus, it warrants bond investors to pay close attention to the 3-month/10-year Treasury spread.

But this is where it gets tricky. A yield curve inversion may be a good predictor of a recession, but it sure is a very poor ‘timer’ of when it would actually happen. The time lag between a yield inversion and an actual recession could span anywhere between 6 months to over 3 years.

3 years is just too long a time an investor can afford to stay away from markets and not have any investment exposure at all.

Data has shown that the reason why most investors perform poorly is because they try to time the market and they get out too early at the first signs of trouble. Similarly, they wait too long to re-enter the market when conditions appear to be recovering which is also too late.

Historically, the sweetest returns are made towards the late-cycle of a market. If we look back at the last 7 recessions, there were 4 periods when markets were up more than 20% after the yield curve inverted. During the late 90s, markets even climbed by over 56% before the recession hit.

Profiting in the Next Recession
So how can you as an investor plan ahead before the last hurrah in markets and the bull party comes to an end? The panic sell-all approach is clearly not the smartest way to go about managing your portfolio as there is money still to be made in a recession as shown above.

Instead, employ late-cycle strategies and consider adding more exposure to dividend stocks and balanced funds to diversify. Fixed income also help investors cushion their portfolios by providing a measure of stability and capital preservation, as drawdown in bond prices are less severe compared to equities in a market downturn. Investors would also have a stable stream of income by reaping the coupons in bonds.

In terms of sector allocation, consider more defensive holdings in consumer staples, utilities, and healthcare. These sectors are less sensitive to global growth and display more resilience in a late-cycle. Cyclicals like tech, bank, energy and industrials still has the potential to outperform, but only if a recession is deemed to occur further in the horizon and the economic cycle can be prolonged. Central banks like the Fed which have turned more dovish could provide the ammunition for monetary stimulus to help extend the cycle and provide more room for markets to run.

Having said that, whether a recession is really around the corner or not should not dictate your entire portfolio decision. The economy moves in boom and bust cycles and a recession is an inevitable phenomenon of markets resetting themselves. It’s a normal albeit insidious part of the economic cycle that can be disruptive to growth and businesses globally. But that has not deterred investors globally from going back to the markets and profiting again.The sooner you realise and accept this as a market truism, the sooner you are able to move on and make constructive decisions about your wealth.

Disclaimer
This article has been prepared by Affin Hwang Asset Management Berhad (hereinafter referred to as “Affin Hwang AM”) specific for its use, a specific target audience, and for discussion purposes only. All information contained within this presentation belongs to Affin Hwang AM and may not be copied, distributed or otherwise disseminated in whole or in part without written consent of Affin Hwang AM.

The information contained in this presentation may include, but is not limited to opinions, analysis, forecasts, projections and expectations (collectively referred to as “Opinions”). Such information has been obtained from various sources including those in the public domain, are merely expressions of belief. Although this presentation has been prepared on the basis of information and/or Opinions that are believed to be correct at the time the presentation was prepared, Affin Hwang AM makes no expressed or implied warranty as to the accuracy and completeness of any such information and/or Opinions.

As with any forms of financial products, the financial product mentioned herein (if any) carries with it various risks. Although attempts have been made to disclose all possible risks involved, the financial product may still be subject to inherent risk that may arise beyond our reasonable contemplation. The financial product may be wholly unsuited for you, if you are adverse to the risk arising out of and/or in connection with the financial product.

Affin Hwang AM is not acting as an advisor or agent to any person to whom this presentation is directed. Such persons must make their own independent assessments of the contents of this presentation, should not treat such content as advice relating to legal, accounting, taxation or investment matters and should consult their own advisers.

Affin Hwang AM and its affiliates may act as a principal and agent in any transaction contemplated by this presentation, or any other transaction connected with any such transaction, and may as a result earn brokerage, commission or other income. Nothing in this presentation is intended to be, or should be construed as an offer to buy or sell, or invitation to subscribe for, any securities.

Neither Affin Hwang AM nor any of its directors, employees or representatives are to have any liability (including liability to any person by reason of negligence or negligent misstatement) from any statement, opinion, information or matter (expressed or implied) arising out of, contained in or derived from or any omission from this presentation, except liability under statute that cannot be excluded.

download